When renting out a property, you can choose between long-term or short-term leases. Long-term leases, lasting six months or more, offer stability and predictable income. Short-term leases, typically under 30 days, provide higher rental rates but fluctuate with seasonal demand and tenant turnover.
Understanding the returns from both options is crucial for your investment strategy. Long-term leases provide steady cash flow and appreciation, while short-term leases can yield higher returns but require more management.
The experts at McCaw Property Management are very experienced with calculating ROI. Here’s our breakdown of both types of leases and how to calculate their returns.
Key Takeaways
- Knowing your ROI is incredibly important for the continuing success of your rental.
- There are many ways to calculate ROI, and results can differ based on your property type.
- Property management teams like McCaw Property Management can assist in optimizing your ROI
Long-Term Lease Property
A long-term lease typically refers to a rental agreement lasting six months or longer. Most residential units, apartments, and commercial real estate fall into this category. These properties tend to generate stable, consistent income. Landlords who rent out their properties long-term can also benefit from property appreciation over time, making this a relatively low-risk investment.
The expected rate of return for a long-term lease property typically falls between 8% and 12% annually. This varies depending on several factors, including the local market, the property’s location, and how well the property is managed.
When calculating returns, you should include both your rental income and any potential capital gains if the property increases in value. However, you also need to factor in operational expenses, taxes, and other costs that could affect your overall return.
Short-Term Lease Property
In contrast to long-term leases, short-term leases refer to rental agreements lasting less than 30 days. These properties can include vacation homes, residential units, or even single rooms in larger homes.
Short-term leases are often advertised on platforms like Airbnb or other short-term rental websites. While short-term leases can provide a higher return, they also come with greater variability in income due to factors like seasonality and tenant turnover.
The expected return on short-term rental properties is generally around 10%, but this can fluctuate depending on factors like seasonal demand. During peak seasons, returns can soar to as high as 20%, while off-peak periods may see returns drop to as low as 5%.
Managing a short-term rental requires careful attention to detail, including guest communication, cleaning, and property upkeep. Location, property type, and effective management are key factors that determine the profitability of short-term rental properties.
Calculating the Rate of Return on a Rental Property
Calculating the rate of return on a rental property is essential for assessing its profitability. By understanding various methods for calculating ROI, property investors can make informed decisions about their investments.
Here are three common approaches.
Simple ROI Calculation
The simplest way to calculate ROI is to subtract the investment cost from the income generated, then divide the result by the initial investment cost. For example, if you invested $400,000 in a rental property and earned $480,000 in total profit, your ROI would be:
ROI = ($480,000 – $400,000) / $400,000 = 0.2 or 20%
While this calculation is straightforward, it doesn’t provide detailed insight into the profitability of your investment compared to other methods.
Cap Rate (Capitalization Rate)
The cap rate is a more detailed calculation used to assess the profitability of a property relative to its purchase price. It’s typically used for evaluating commercial properties but can also be applied to residential investments. The cap rate formula is:
Net Operating Income (NOI) = Rental Income – Operating Expenses
Cap Rate = (NOI / Purchase Price) x 100%
For example, if your property was purchased for $600,000 with an additional $66,000 spent on closing costs and renovations, your total investment would be $666,000. If your property generates $4,000 in monthly rent, or $48,000 annually, and your operating expenses are $8,000, your NOI would be $40,000. The cap rate would be:
Cap Rate = ($40,000 / $666,000) x 100% = 6.01%
While the cap rate method is useful, it is less effective for short-term rentals as it requires a comparison of similar property values within a specific area.
Cash on Cash Return (COC)
Cash-on-cash return (COC) is a method that focuses on the actual cash invested in a property, making it especially useful when financing a rental through a mortgage. The formula is:
COC = (Annual Cash Flow / Total Cash Investment) x 100%
For instance, if you purchased a rental property for $600,000, made a 20% down payment of $120,000, and spent $9,000 on closing costs and $40,000 on renovations, your total cash investment would be $169,000. If the property generates $6,000 in rent per month but you have $4,000 in monthly mortgage payments, your monthly cash flow would be $2,000, or $24,000 annually. Using the COC formula:
COC = ($24,000 / $169,000) x 100% = 14.2%
A good cash-on-cash return is typically between 8% and 12%, with some investors targeting at least 20% for a property to be considered a worthwhile investment.
Bottom Line
Each of these methods, simple ROI, cap rate, and cash-on-cash return, provides valuable insight into the potential returns from a rental property. However, the cash-on-cash return calculation is often regarded as the most useful, especially when financing a property with a loan. This method gives you a clearer picture of your actual cash returns, factoring in the expenses associated with financing a property.
For those who are new to property investing or looking to optimize their rental income, having a professional property management team can help streamline the process. Property managers are well-versed in handling everything from tenant screening and rent collection to maintenance and legal issues. They can also assist with calculating taxes, keeping financial records, and ensuring that you’re taking advantage of all available tax deductions.
For expert support in managing your rental property, consider partnering with McCaw Property Management. Our expertise can handle the complexities of property management, allowing you to focus on growing your investment while we manage the day-to-day operations.